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The U.S. Dollar Index Breaks Out

With the algos gone berserk in the stock market of late, not many investors noticed that we are now trading at a fresh 52-week high on the old U.S. Dollar Index. All indications are that the dollar is headed higher, with better economic performance, a shrinking trade deficit, and higher interest rates, based on the latest indications from the Federal Reserve.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

As I have often noted in this column, a lot has changed in global trade since the non-trade-weighted U.S. Dollar Index was formulated. That index still carries the euro as its largest component at 57.6%.

Even though the euro has been around in cash form for less than 20 years, its exchange rate can be extrapolated back in time using the formula under which Deutsche marks and French francs (and the other European currencies) got folded into the euro. Under such a historical exercise, the range of the euro over the past 50 years is $0.69 to $1.87. Its purchasing power parity, which is a nebulous concept due to the various standards of living for all countries that are part of the eurozone, is around $1.15.

Still, currencies are famous for swinging from wildly undervalued to wildly overvalued and not respecting such theoretical concepts as “purchasing power parity.” With existential frictions within the EU and eurozone, due to Brexit and Italy and the wave of populism that was catalyzed by the refugee crisis, the euro has some very serious issues. Economic performance of eurozone countries has notably decelerated in 2018, which is also evident in underperforming eurozone stock benchmark indexes like Euro Stoxx 50 (similar to the Dow Jones Industrial index) and Euro Stoxx 600 (similar to the S&P 500).

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The Euro Stoxx 50 Index appears to have double-topped and failed even to take out its 2007 highs, while the Dow Jones Industrial Average has for all intents and purposes doubled in the same time frame. With more economic momentum in the U.S. and expanding interest rate differentials, it appears that the euro is headed lower. On a daily euro chart, there is a clearly definable head-and-shoulders top, which is a trading pattern that points to an exchange rate of 1-to-1, or “parity” to the dollar. Such a euro bear market is likely to continue to unfold in 2019 after having started earlier this year from above $1.25.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The cyclical bull market that took the euro from under $1.04 on the first trading day in 2017 to its early 2018 highs was driven by pro-EU election victories. Exactly the opposite political environment is present, with the populist government in Italy butting heads with Brussels, and Brexit frictions intensifying.

The Trade-Weighted Dollar Is Much Stronger

The all-time high in the Broad Trade-Weighted Dollar Index, set in early 2002, is 130.21. We reached 127.55 last week. While the Broad Trade Weighted Dollar index was hitting its all-time high in 2002, the old (non-trade-weighted) U.S. Dollar Index was near 120. It closed on Friday at 96.51. It is pretty clear that on a trade-weighted basis the dollar is much stronger and close to fresh all-time highs, which are coming soon as the Trump administration keeps tackling trade issues and the Fed keeps hiking interest rates.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Clearly, the trade friction with China is on stock investors’ minds as the stock market sees notable waves of buying on any seemingly positive developments from the present standoff and then sells off when other more negative news headlines nip the hopes for a trade deal in the bud. The President asked his staff last week to draft a trade deal to present to Xi at the G-20 summit in Argentina later this month.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

President Trump also said recently that if there is no trade deal at the G-20 Summit, he will slap China with more tariffs, which does not qualify as a thinly-veiled threat when it comes on the rating scale of threats. The thing with the Chinese is that they do not respond very well to threats and they always try to save “face”; the present U.S. trade strategy is as far from face-saving for the Chinese as it is likely to get.

Still, the abrasive approach preferred by President Trump has produced results with Mexico, Canada, and South Korea, so he is hoping it will produce the same results with China and Japan. I have my doubts.

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